How does currency momentum investing work?

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AcadiFi · Accepted Answer

Currency momentum buys currencies that have appreciated recently and sells those that have depreciated, similar in spirit to equity momentum but with different risk characteristics. Construction: rank G10 or expanded universe by trailing 3-12 month returns against a common base (typically USD), go long top quintile, short bottom quintile, rebalance monthly. Academic and practitioner studies (Menkhoff, Sarno, Schmeling, Schrimpf) find robust momentum premia of 4-6% annually with Sharpe 0.5-0.7 in G10 and higher in emerging markets. Drivers: behavioral under-reaction to rate differentials and policy divergences; capital flow momentum (foreign investors chasing strong currencies); carry overlap (high-yielding currencies tend to have momentum because their higher rates attract flows). Lookback periods of 3-6 months work well in FX — shorter than equity (6-12 months) because FX reverses faster. Momentum and carry have correlation around 0.3-0.5, sharing some return drivers but diverging sharply during regime shifts (e.g., central bank pivots cause momentum to flip before carry does). Risk management: drawdown control via volatility targeting, crash scaling during VIX spikes, and rebalancing discipline. Transaction costs matter — G10 FX has 0.5-2bps bid-ask, allowing high turnover strategies to survive. Implementation via deliverable forwards with monthly rolls. Post-2022, momentum strategies benefited from divergent central bank paths as Fed tightened, BOJ eased, and ECB lagged — creating persistent trends. Momentum also works as a diversifier within multi-factor FX portfolios because its correlation with carry crashes is negative during the crash onset.

How does currency momentum investing work?

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